Small business owners who form a limited liability company (LLC) as their business entity should have a thorough understanding of the entity and its benefits. This is especially true when the business will have more than one owner, also called a multi-member LLC. To ensure everyone understands their responsibilities to the LLC, as well as each owners’ ownership percentage in the business, owners should create an LLC operating agreement.
What is an LLC Operating Agreement?
An operating agreement is a legal document between LLC members that describes the rights and duties of its members. It is a set of business operations guidelines that apply both now and into the future. An operating agreement should be written and kept in the company’s records. This allows each member of the LLC to review the document and update it on an annual basis.
Why Do I Need an LLC Operating Agreement Document?
One major benefit of an LLC is the limited liability of its members. The operating agreement is where this liability is formally written, making it a crucial document. Without the formality of an operating agreement, the government may instead decide that your business is a sole proprietorship or a partnership when taxing your business. Protect your personal liability and personal assets by ensuring that limited liability status is explicitly in writing.
The operating agreement is also a great place to explicitly write down the content of any handshake agreement or oral agreement between you and your co-owner. Miscommunication is and will always be a huge business problem. Put your business arrangements in writing to prevent misunderstandings.
What’s Included in an LLC Operating Agreement?
The following nine common provisions should be included in your LLC operating agreement:
- Basic Contact and Term Details
- Business Purpose
- Members’ Roles and Responsibilities
- Tax Structure
- Member Admittance
- Member Withdrawal or Passing
- Dissolution Provisions
As you create your LLC operating agreement, we highly recommend that you consult a business attorney or other legal services to check your document.
1. Basic Contact and Term Details
This clause covers the basic contact details and the term of the LLC. Basic contact information includes the name of the LLC, the name and address of each member, the address of the LLC’s principal business location, and the registered agent’s name and address.
Term information relates to the LLC’s start date. This includes the day, month, and year the LLC is officially in business.
2. Business Purpose
What kind of business does your LLC do? Sum up the activities and purpose of the LLC. Usually, this is a general description. It does not need to be any longer than one sentence.
3. Members’ Roles and Responsibilities
Use this section to detail the roles and responsibilities of the LLC’s members.
Clearly define the role that each member plays in the business and their daily responsibilities. This allows members to better understand the division of labor in the business and exactly what is expected of them in their given roles. Should there be any disputes between members, it is helpful to refer to this clause to resolve any conflicts.
4. Ownership Rights
Ownership examines what each member is entitled to in an LLC.
First, the operating agreement will note the company’s LLC business structure. This may be single-member LLC, member-managed LLC, or manager-managed LLC. Once the company business structure is decided, it will be easier to determine the portion of the LLC’s profits, losses, and assets each member receives by dividing the initial investment.
For example, in a single-member LLC there is only one member. This single member contributes a specific amount of capital to the company. That amount is 100% theirs. It does not need to be divided against any other members because there is only one member.
However, a structure like a member-managed LLC may have two members. Let’s say both members each invested equal amounts into the LLC. The amount is then split on a 50/50 basis. If the members did not invest equal amounts into the LLC, the ownership clause will further detail what the profit and loss terms look like for each member as well as their specific capital contributions. These profit and loss shares, called “distributive shares,” usually correspond to each member’s ownership percentage.
It’s critical to discuss ownership rights with all members and make sure they understand and agree to the division of profits, losses, and assets.
You may also include information about member voting rights in this section, or another section. While some businesses lump voting rights and ownership rights in a single section, others separate them completely.
5. Capital, Profit, and Loss
This section covers the initial capital contributions of each LLC member. It also details each member’s profit and loss terms. Remember to detail which bank account this money will be kept in, as well as how and when LLC members are paid.
You may also include information about which member will be responsible if additional capital is required, and what will happen if a member is unable to contribute additional capital.
In this section, it may also be wise to define how much of the allocated profits — distributive shares — will be distributed to LLC members each year.
6. Tax Structure
How does your LLC plan to be taxed? Indicate the method the LLC chooses to be taxed, such as electing S Corporation status, for members to review.
7. Member Admittance
Will your LLC admit new members? If so, instructions need to be outlined for new member admittance.
Some information to consider when drafting these guidelines includes outlining the roles and responsibilities of new members, their capital contributions, and what they may receive for joining the LLC. (If you do not plan to admit new members, such as being a single-member LLC, please make note of this decision.)
8. Member Withdrawal or Passing
Guidelines should also be put into place for any member who decides to voluntarily, or involuntarily, withdraw from the LLC.
Like the rules for new member admittance, the withdrawal process outlines what departing members are entitled to and how long they are allowed to be involved with the business. You may review this section with other members for their feedback and to make sure everyone understands the guidelines.
What if a member passes away? Use this clause to outline how the LLC’s ownership will be redistributed among its members. Any next steps moving forward, such as liquidating the business or purchasing the decedent’s interest, should be detailed in the operating agreement.
9. Dissolution Provisions
Sometimes the passing of an LLC member can lead to the dissolution, or formal closure, of the LLC.
Include a clause with terms for dissolution provisions. This section should detail how to divide the remaining assets of the LLC among its members and whether members may be allowed to start or run businesses based on the idea of the dissolved LLC.
Wrap up the LLC operating agreement with a brief severability provision. This is a standard legal boilerplate. It states that if by chance a provision of the LLC operating agreement runs contrary to state or federal law, all other aspects that are not contrary to the law should still survive.
Bonus: Special Agreements
Depending on the type of company and your business structure, you may include special terms in your LLC operating agreement. These could include non-compete agreements, settlement agreements, or conflict of interest policies. It could also include a non-disclosure agreement.
The Value of an LLC Operating Agreement
An LLC operating agreement is a crucial document that solidifies the structure of your limited liability company and its purpose. It keeps its owners safe. This document enables members to successfully run a business now and into the future.
Allow each member of the LLC to review the LLC operating agreement and sign it. Once it has been signed, it may act as an official document for the LLC’s financial and functional decisions.
Deborah Sweeney is the CEO of MyCorporation.com. MyCorporation is a leader in online legal filing services for entrepreneurs and businesses, providing start-up bundles that include corporation and LLC formation, registered agent, DBA, and trademark & copyright filing services. MyCorporation does all the work, making the business formation and maintenance quick and painless, so business owners can focus on what they do best. Follow her on Twitter @deborahsweeney and @mycorporation.
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