Business owners understand the importance of forming a limited liability company (LLC) to receive not only limited liability protection but also the tax and other benefits of an LLC. An LLC Operating Agreement is the document in which you’ll describe how you want to run your company by setting the internal rules for its owners — also known as members. Even if your state doesn’t require you to draft an Operating Agreement, your company can benefit from having one. Formation under state law is only the first step in completing the LLC organizational process. Don’t forget to also create an Operating Agreement for your LLC.
Read on to learn what topics an LLC Operating Agreement typically covers, how they work, their key requirements, and why your LLC needs one.
What are the Key Parts of an LLC Operating Agreement?
Did you know that when you form an LLC under state law, the LLC doesn’t have any members (owners) unless you specifically list them in the Articles of Organization? Because most state LLC laws don’t require the LLC’s Articles of Organization to list any members, 98 percent of new LLCs don’t have members right after formation.
The most common way to issue ownership interests in an LLC is through an LLC Operating Agreement. While the sections of an Operating Agreement may vary, most contain six key sections: “Organization,” “Management and Voting,” “Capital Contributions,” “Distributions,” “Membership Changes,” and “Dissolution.”
Take time to consider the following provisions as you decide which sections to include in your LLC Operating Agreement. You should tailor this document to the unique needs of your company.
The first part of an Operating Agreement deals with the formation of the company. It notes the company’s formation date, members, ownership structure, and overall purpose.
Management and Voting
An LLC either has a member-managed or manager-managed management structure. In a member-managed LLC, the company’s owners are responsible for the day-to-day operations. In a manager-managed LLC, the company brings in a third party to handle its daily affairs. In either case, you also might list the particular rights and responsibilities of each member in this section.
An LLC may elect to make decisions through a voting process. LLCs can allocate votes among their members in many ways, including one vote per member or one vote per unit of ownership interest.
This section lists any contributions from an LLC’s members at the time of formation. Contributions might include monetary contributions, loans the LLC must repay, and physical assets. This section also should cover how the members will raise additional money.
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.
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?
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 assets upon dissolution.
Do I Need an Operating Agreement?
LLCs in California, Delaware, Maine, Missouri, Nebraska, and New York are legally required to have an Operating Agreement. Whenever your LLC faces a major change, such as bringing on a new owner or expanding its services, having an Operating Agreement in place can prove helpful. 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.
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, statutory rules govern their operations. For example, in Texas, an LLC must distribute its profits and losses to each member of the company according to the agreement of each member’s contributions as stated in the company’s records. If there’s no agreement in the company’s records, the members expose themselves to risks that can lead to lawsuit claims.
Also, a member may face significant internal issues with another LLC member. If LLC members don’t consult an attorney during the LLC formation process and never create an Operating Agreement, they usually must pay substantial sums of money to litigate issues they could have prevented with a well-written Operating Agreement. An Operating Agreement helps LLC members avoid costly legal troubles and, ultimately, protect themselves.
What Happens After Completing an Operating Agreement?
An LLC doesn’t need to file their Operating Agreement with the state, but some states require LLCs to have an Operating Agreement on file internally at the company while many more states don’t require LLCs to have one.
A few states — including California, Delaware, Maine, Missouri, Nebraska, and New York — do require LLCs to file their Operating Agreements with the relevant state agency.
An Operating Agreement is just one of the key tasks you need to complete after forming an LLC. Here are six other next steps you should take after completing your Operating Agreement.
Get an EIN
After creating an Operating Agreement, it’s time to obtain an Employer Identification Number (EIN). An EIN essentially acts like a Social Security number for your LLC. The Internal Revenue Service (IRS) issues EINs and uses them to keep track of each 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 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 where the “limited liability” in LLC comes in.
Mixing your personal bank account with your business’s bank account — called “commingling” — will break that corporate veil. That’ll open your personal bank account to undue exposure and completely negate 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.
Key Elements of an LLC Operating Agreement FAQ
Do LLCs have Operating Agreements?
Some states, such as California, Delaware, Maine, Missouri, Nebraska, and New York, require LLCs to have an Operating Agreement. Other states may not require an Operating Agreement, but it’s best to have one to outline the ownership and member duties of your LLC.
What do you do with an Operating Agreement?
An Operating Agreement lets you keep tabs on what you and the other members of your LLC agreed to regarding the management of the company and making changes in the business.
Can I create my own Operating Agreement for my LLC?
Yes, especially if you own a single-member LLC. Even if you start out on your own, there may come a time when you wish to take on one or more members. When that happens, your Operating Agreement serves as a binding contract among the members.
How do I change my LLC Operating Agreement?
You can change or update your Operating Agreement if any major developments occur within your business. If members or ownership interests change — or if alterations to other factors referred to in your Operating Agreement occur — it’s important to update the document to reflect those changes.
What needs to be in an Operating Agreement?
An Operating Agreement typically includes six key sections, including “Organization,” “Management and Voting,” “Capital Contributions,” “Distributions,” “Membership Changes,” and “Dissolution.” For more details, see the What Are the Key Parts of an LLC Operating Agreement? section above.
How much does an Operating Agreement cost?
Writing an Operating Agreement doesn’t cost anything unless you hire a business attorney to do it for you.
Who signs an Operating Agreement?
Each member of your LLC should sign the Operating Agreement on a separate signature page.
Does an Operating Agreement need to be notarized?
While an Operating Agreement doesn’t require notarization, some businesses opt to have this document notarized to make it more legitimate and official.
What happens if my LLC doesn’t have an Operating Agreement?
Without an Operating Agreement, an LLC may face increased exposure to legal troubles, can be subject to state default laws, and can have internal problems with members in the future.