Key Elements of an LLC Operating Agreement

Understanding the key elements of an LLC operating agreement is crucial for any business owner as it outlines the structure, roles, and responsibilities within your LLC, ensuring clarity and preventing disputes.

In this article, we’ll explore what an LLC operating agreement typically covers, their key requirements, and why your LLC needs one.

What Is an Operating Agreement

An operating agreement is a legal document used by LLCs to outline the rules and structure of the business. It normally details how the LLC will be managed, how decisions will be made, and the rights and responsibilities of the members.

The purpose of an operating agreement is to establish clear rules and guidelines for running an LLC. This helps prevent conflicts by providing a clear framework to ensure smooth operations and protect the interests of all members.

Despite not being a legal requirement for LLCs in most states, any operating agreement that is officially drafted will be recognized as legally binding.

Key Parts of an LLC Operating Agreement

The most common way to issue ownership interests in a limited liability company (LLC) is through an Operating Agreement. While its contents can vary, this document is typically made up of the following six key sections:

1. Organization
2. Management and Voting
3. Capital Contributions
4. Distributions
5. Membership Changes
6. Dissolution

In the sections below, we’ve broken down each of these key components in greater detail.

1. Organization

The first part of an Operating Agreement deals with the formation of the company. This should include the date the company was formed, its members details, ownership structure, and overall purpose.

In particular, this section should focus on the ownership percentages of each member/owner, as well as how much they all initially contributed toward the company.

2. Management and Voting

LLCs can have one of two management structures: member-managed or manager-managed.

In a member-managed LLC, the company’s owners are responsible for the day-to-day operations, while in a manager-managed LLC, the company brings in a third party to handle its daily affairs.

This section of your operating agreement should list which type of management structure it plans to be, as well as the particular rights and responsibilities of each member.

Additionally, your LLC can also elect to make decisions through a voting process in this section by allocating votes among their members (e.g., one vote per member or one vote per unit of ownership interest).

3. Capital Contributions

This section lists the capital contributions from each of an LLC’s members — which might include monetary contributions, loans the LLC must repay, and physical assets. Additionally, this section should also cover how the members will raise additional money.

4. Distributions

This section outlines how and when an LLC will distribute profits to its members. Distributions might be in proportion to member contributions, but not necessarily. If the LLC operates at a loss, you’ll also distribute the loss among the members at the end of the fiscal year.

The members will then need to report that loss on their individual tax returns. To prepare for a tax year that ends in a loss, the operating agreement should allocate a percentage of potential losses to each member.

5. Membership Changes

In this section, you’ll outline your LLC’s procedures for adding or removing members as well as noting if members may transfer their interests to a third party or another member and how you’ll value a member’s interest.

If you prohibit transfers, consider what’ll happen if a member dies, goes bankrupt, or becomes incapacitated. Will these events result in the LLC’s dissolution or will an appointed member or beneficiary step into that member’s shoes?

6. Dissolution

This section explains the circumstances in which the company may — or must — be dissolved. Some LLCs will dissolve after a specific date or event while others will continue indefinitely until the members agree to close the business.

This section also should list how the members will distribute the remaining company assets (at a fair market value) upon dissolution.

Do I Need an Operating Agreement For My LLC

Except for the following six states, it’s not a legal requirement for LLCs to draft an operating agreement in order to be registered:

• California
• Delaware
• Maine
• Missouri
• Nebraska
• New York

However, even in states where it’s not legally mandated, it’s still a good idea for an LLC to maintain a written operating agreement.

In particular, operating agreements are extremely helpful whenever an LLC faces major changes — such as when a new member joins or it expands its services — as it should provide some direction on what to do.

Even if you don’t experience any major changes in the business, take a look at the agreement every year to see if it continues to reflect the needs of your company and its members.

Note: The aforementioned six states require all LLCs to have an operating agreement, meaning you’ll need to draft one even if you’ve formed a single member LLC.

Why is an Operating Agreement Important?

While you don’t need to file your Operating Agreement with your state, that doesn’t mean you should skip this step. If you don’t have this document in place and something happens to you or another member of your LLC, it’s possible that the state could step in to settle any disputes.

It’s better to outline your LLC’s operating procedures from the beginning to prevent future issues among members.

What if an LLC Has No Operating Agreement?

When LLCs fail to establish operating agreements, their operations are instead governed by statutory rules, which tend to be much less flexible and may not align with the members’ needs.

For example, according to default rules in Texas, an LLC’s members expose themselves to risks that can lead to lawsuit claims if there’s no agreement of each member’s contributions as stated in the company’s records.

Additionally, LLC members that don’t consult an attorney during the LLC formation process and never create an operating agreement are usually required to pay substantial sums of money to litigate issues they could have prevented with a well-written operating agreement.

In this way, an operating agreement helps LLC members avoid costly legal troubles and, ultimately, protect themselves.

Next Steps After Completing an Operating Agreement

Even in states where you’re required to draft an operating agreement, you’ll never be required to file it with the state. Instead, all you need to do is keep it in your business records for internal reference and compliance.

After properly forming your LLC and drafting an operating agreement, there are a number of other steps you’ll need to complete, which we’ve broken down in more depth below.

Get an EIN

After creating an Operating Agreement, it’s time to obtain an Employer Identification Number (EIN). This is a nine-digit number assigned to you by the Internal Revenue Service (IRS) that essentially acts like a Social Security number for your LLC; it will be used to keep track of your business’s tax reporting.

You’ll need an EIN to:

• Open a business bank account and/or credit card
• Hire employees
• File for tax returns
• Separate your personal assets from your business

Open a Business Bank Account

The LLC business structure works to separate your company’s business assets from your personal assets. This separation — called the corporate veil — protects your personal assets if your business ever faces a lawsuit or incurs any other financial debts. This is what prevents you from being held personally liable.

Mixing your personal bank account with your business’s bank account — called “commingling” — will break that corporate veil and open a personal bank account to undue exposure that completely negates the asset protection your LLC was meant to provide.

You can avoid this by opening a business bank account with your EIN and transferring in any initial funds. But, remember to document this funds transfer in your company’s official records.

If you ever need to take money out of the business or invest more of your personal funds, make sure to also keep records of these transactions. This includes the transfers you make when paying yourself a “salary.”

Create an Accounting System

You need to create an accounting system for your business to maintain a general ledger that tracks your LLC’s finances, including bills, expenses, and income. You can hire a certified public accountant (CPA) or do it yourself.

The main accounting issue related to operating an LLC involves the payment of income taxes. Income should flow through an LLC to its owners (as is the case with a partnership) so the business itself doesn’t pay taxes. LLCs distribute their profits and losses to their members based on their ownership interests. This arrangement makes an LLC a “pass-through entity.”

Register for State Sales Taxes

Specific types of businesses must apply to collect and submit state sales taxes. The state sales taxes you need will depend on your state and the type of business you plan to operate.

If your business engages in any of the following, you’ll need to apply for state sales taxes:

• Your business will sell or lease personal property (tangible items)
• Your business will offer taxable services

Get Required Licenses and Permits

Your LLC may need to obtain certain licenses and permits, depending on the nature of your business, your state’s laws, and the local laws in your community. Once you determine the different location-based licenses and permits your LLC needs, you’ll also need to obtain any licenses and permits required by your industry. Industry-specific licenses and permits include a real estate license, an insurance license, a liquor license, and so on.

Obtain Business Insurance

It’s important to have the proper insurance policies in place for your LLC to safeguard your assets. A few of the most common business insurance policies include general liability insurance, professional liability insurance, and workers’ compensation insurance.